Bank of England lays down guidelines on OTC derivatives

The Bank of England has set out its suggestions on how to determine which OTC derivatives can be made eligible for central clearing, as part of the government’s G20 commitment to reducing systemic risk in financial markets.

The Bank of England has set out its suggestions on which OTC derivatives should be made eligible for central clearing, as
part of the UK government’s Group of 20's commitment to reducing systemic risk in financial
markets.

Published in a report, 'Thoughts on determining central
clearing eligibility of OTC derivatives', the Bank of England argued that suitability
for mandatory central clearing depends first on product and process
standardisation and secondly on market liquidity. Key considerations identified are usage of standard legal terms, use of straight-through processing
and electronic confirmation and accessible measures of liquidity.

Less liquid products, or products for
which operational processes remain less automated, are unlikely to be suitable
for central clearing, according to the report. Despite this, it also suggests that central counterparties (CCPs) may need to
modify risk management models developed for more liquid products, to
accommodate the less liquid OTC products.

In addition, the paper suggests that the industry may need
more specific guidance from the authorities as to which OTC derivatives should
be centrally cleared. The Bank of England acknowledges that this would likely
need close and coordinated engagement with CCPs, as well as the main dealers.

“There is an urgent need to develop precise and timely
metrics to monitor central clearing progress, work which was highlighted as a
priority in the October 2011 Financial Stability Board progress report,” said the paper.

The G20
nations mandated a reform of the structure and transparency of OTC derivatives
following the financial crisis. Reforming the sector was seen as a
key means to reduce systemic risk, since many of the products that contributed
to the collapse of certain large financial institutions were complex OTC
instruments.

In Europe,
the proposed European market infrastructure regulation (EMIR) seeks to transfer
as large a proportion of current OTC trading as possible onto centrally cleared
platforms. The European Securities and Markets Authority ended its consultation on EMIR – including which products are eligible for clearing – last week.

Market participants will be forced to post collateral and set aside
margin to be used in the event of a default of one of the parties to a
transaction. This process is intended to reduce the possibility that the
default of one institution could have a catastrophic knock-on effect on
financial markets. Implementation of EMIR is currently scheduled for the start
of next year.